Tag Archives: QT

Yeah…But

Yeah… Barry Bonds, a Major League Baseball (MLB) player, put up some amazing stats in his career. What sets him apart from other players is that he got better in the later years of his career, a time when most players see their production rapidly decline.

Before the age of 30, Bonds hit a home run every 5.9% of the time he was at bat. After his 30th birthday, that rate almost doubled to over 10%. From age 36 to 39, he hit an astounding .351, well above his lifetime .298 batting average. Of all Major League baseball players over the age of 35, Bonds leads in home runs, slugging percentage, runs created, extra-base hits, and home runs per at bat. We would be remiss if we neglected to mention that Barry Bonds hit a record 762 homeruns in his MLB career and he also holds the MLB record for most home runs in a season with 73.

But… as we found out after those records were broken, Bond’s extraordinary statistics were not because of practice, a new batting stance, maturity, or other organic factors. It was his use of steroids. The same steroids that allowed Bonds to get stronger, heal quicker, and produce Hall of Fame statistics will also take a toll on his health in the years ahead.  

Turn on CNBC or Bloomberg News, and you will inevitably hear the hosts and interviewees rave on and on about the booming markets, low unemployment, and the record economic expansion. To that, we say Yeah… As in the Barry Bonds story, there is also a “But…” that tells the whole story.

As we will discuss, the economy is not all roses when one considers the massive amount of monetary steroids stimulating growth. Further, as Bonds too will likely find out at some point in his future, there will be consequences for these performance-enhancing policies.

Wicksell’s Wisdom

Before a discussion of the abnormal fiscal and monetary policies responsible for surging financial asset prices and the record-long economic expansion, it is important to impart the wisdom of Knut Wicksell and a few paragraphs from a prior article we published entitled Wicksell’s Elegant Model.

“According to Wicksell, when the market rate (of interest) is below the natural rate, there is an incentive to borrow and reinvest in an economy at the higher natural rate. This normally leads to an economic boom until demand drives up the market rate and eventually chokes off demand. When the market rate exceeds the natural rate, borrowing slows along with economic activity eventually leading to a recession, and the market rate again falls back below the natural rate. Wicksell viewed the divergences between the natural rate and the market rate as the mechanism by which the economic cycle is determined. If a divergence between the natural rate and the market rate is abnormally sustained, it causes a severe misallocation of capital.

Per Wicksell, optimal policy should aim at keeping the natural rate and the market rate as closely aligned as possible to prevent misallocation. But when short-term market rates are below the natural rate, intelligent investors respond appropriately. They borrow heavily at the low rate and buy existing assets with somewhat predictable returns and shorter time horizons. Financial assets skyrocket in value while long-term, cash-flow driven investments with riskier prospects languish. The bottom line: existing assets rise in value but few new assets are added to the capital stock, which is decidedly bad for productivity and the structural growth of the economy.

Essentially, Wicksell warns that when interest rates are lower than they should be, speculation in financial assets is spurred and investment into the real economy suffers. The result is a boom in financial asset prices at the expense of future economic activity. Sound familiar? 

But… Monetary Policy

The Fed’s primary tool to manage economic growth and inflation is the Fed Funds rate. Fed Funds is the rate of interest that banks charge each other to borrow on an overnight basis. As the graph below shows, the Fed Funds rate has been pinned at least 2% below the rate of economic growth since the financial crisis. Such a low relative rate spanning such a long period is simply unprecedented, and in the words of Wicksell not “optimal policy.” 

Until the financial crisis, managing the Fed Funds rate was the sole tool for setting monetary policy. As such, it was easy to assess how much, if any, stimulus the Fed was providing at any point in time. The advent of Quantitative Easing (QE) made this task less transparent at the same time the Fed was telling us they wanted to be more transparent.  

Between 2008 and 2014, through three installations of QE, the Fed bought nearly $3.2 trillion of government, mortgage-backed, and agency securities in exchange for excess banking reserves. These excess reserves allowed banks to extend more loans than would be otherwise possible. In doing so, not only was economic activity generated, but the money supply rose which had a positive effect on the economy and financial markets.

Trying to quantifying the amount of stimulus offered by QE is not easy. However, in 2011, Fed Chairman Bernanke provided a simple rule in Congressional testimony to allow us to transform a dollar amount of QE into an interest rate equivalent. Bernanke suggested that every additional $6.6 to $10 billion of excess reserves, the byproduct of QE, has the effect of lowering interest rates by 0.01%. Therefore, every trillion dollars’ worth of new excess reserves is equivalent to lowering interest rates by 1.00% to 1.50% in Bernanke’s opinion. In the ensuing discussion, we use Bernanke’s more conservative estimate of $10 billion to produce a .01% decline in interest rates.

The graph below aggregates the two forms of monetary stimulus (Fed Funds and QE) to gauge how much effective interest rates are below the rate of economic growth. The blue area uses the Fed Funds – GDP data from the first graph. The orange area representing QE is based on Bernanke’s formula. 

Since the financial crisis, the Fed has effectively kept interest rates 5.11% below the rate of economic growth on average. Looking back in time, one can see that the current policy prescription is vastly different from the prior three recessions and ensuing expansions. Following the three recessions before the financial crisis, the Fed kept interest rates lower than the GDP rate to help foster recovery. The stimulus was limited in duration and removed entirely during the expansion. Before comparing these periods to the current expansion, it is worth noting that the amount of stimulus increased during each expansion. This is a function of the growth of debt in the economy beyond the economy’s growth rate and the increasing reliance on debt to generate economic growth. 

The current expansion is being promoted by significantly more stimulus and at much more consistent levels. Effectively the Fed is keeping rates 5.11% below normal, which is about five times the stimulus applied to the average of the prior three recessions. 

Simply the Fed has gone from periodic use of stimulus to heal the economy following recessions to a constant intravenous drip of stimulus to support the economy.

Moar

Starting in late 2015, the Fed tried to wean the economy from the stimulus. Between December of 2015 and December of 2018, the Fed increased the Fed Funds rates by 2.50%. They stepped up those efforts in 2018 as they also reduced the size of their balance sheet (via Quantitative Tightening, “QT”) from $4.4 trillion to $3.7 trillion.

The Fed hoped the economic patient was finally healing from the crisis and they could remove the exorbitant amount of stimulus applied to the economy and the markets. What they discovered is their imprudent policies of the post-crisis era made the patient hopelessly addicted to monetary drugs.

Beginning in July 2019, the Fed cut the target for the Fed Funds rate three times by a cumulative 0.75%. A month after the first rate cut they abruptly halted QT and started increasing their balance sheet through a series of repo operations and QE. Since then, the Fed’s balance sheet has reversed much of the QT related decrease and is growing at a pace that rivals what we saw immediately following the crisis. It is now up almost a half a trillion dollars from the lows and only $200 billion from the high watermark. The Fed is scheduled to add $60 billion more per month to its balance sheet through April. Even more may be added if repo operations expand.

The economy was slowing, and markets were turbulent in late 2018. Despite the massive stimulus still in place, the removal of a relatively small amount of stimulus proved too volatility-inducing for the Fed and the markets to bear.

Summary

Wicksell warned that lower than normal rates lead to speculation in financial assets and less investment into the real economy. Is it any wonder that risk assets have zoomed higher over the last five years despite tepid economic growth and flat corporate earnings (NIPA data Bureau of Economic Analysis -BEA)? 

When someone tells you the economy is doing fine, remind them that Barry Bonds was a very good player but the statistics don’t tell the whole story.

To provide further context on the extremity of monetary policy in America and around the world, we present an incredible graph courtesy of Bianco Research. The graph shows the Bank of England’s balance sheet as a percentage of GDP since 1700. If we focus on the past 100 years, notice the only period comparable to today was during World War II. England was in a life or death battle at the time. What is the rationalization today? Central banker inconvenience?

While most major countries cannot produce similar data going back that far, they have all experienced the same unprecedented surge in their central bank’s balance sheet.

Assuming today’s environment is normal without considering the but…. is a big mistake. And like Barry Bonds, who will never know when the consequences of his actions will bring regret, neither do the central bankers or the markets. 

UPDATE: To Buy, Or Not To Buy- An Investors Guide to QE 4

In our RIA Pro article, To Buy, Or Not To Buy- An Investors Guide To QE4, we studied asset performance returns during the first three episodes of QE. We then normalized the data for the duration and amount of QE to project how QE4 might affect various assets.  

With a month of QE4 under our belt, we update you on the pacing of this latest version of extreme monetary policy and review how various assets are performing versus our projections. Further, we share some recent comments from Fed speakers and analyze trading in the Fed Funds market to provide some unique thoughts about the future of QE4.

QE4

Since October 14th, when QE4 was announced by Fed Chairman Jerome Powell, the Fed’s balance sheet has increased by approximately $100 billion. The graph below compares the current weekly balance sheet growth with the initial growth that occurred during the three prior iterations of QE.  

Data Courtesy St. Louis Federal Reserve

As shown above, the Fed is supplying liquidity at a pace greater than QE2 but slightly off the pace of QE 1 and 3. What is not shown is the $190 billion of growth in the Fed’s balance sheet that occurred in the weeks before announcing QE4. When this amount is considered along with the amount shown since October 14th, the current pacing is much larger than the other three instances of QE.

To put this in context, take a step back and consider the circumstances under which QE1 occurred. When the Fed initiated QE1 in November of 2008, markets were plummeting, major financial institutions had already failed with many others on the brink, and the domestic and global economy was broadly in recession. The Fed was trying to stop the worst financial crisis since the Great Depression from worsening.

Today, U.S. equity markets sit at all-time highs, the economic expansion has extended to an all-time record 126 months, unemployment at 3.6% is at levels not seen since the 1960s, and banks are posting record profits.

The introduction of QE4 against this backdrop reveals the possibility that one of two things is occurring, or quite possibly both.

One, there could be or could have been a major bank struggling to borrow or in financial trouble. The Fed, via repo operations and QE, may be providing liquidity either to the institution directly or indirectly via other banks to forestall the ramifications of a potential banking related default.

Two, the markets are struggling to absorb the massive amount of Treasury debt issued since July when Congress extended the debt cap. From August through October 2019, the amount of Treasury debt outstanding grew by $1 trillion. Importantly, foreign entities are now net sellers of Treasury debt, which is worsening the problem. For more read our recent article, Who Is Funding Uncle Sam?

The bottom line is that the Fed has taken massive steps over the last few months to provide liquidity to the financial markets. As we saw in prior QEs, this liquidity distorts financial markets.  

QE4 Projections and Updates

The following table provides the original return projections by asset class as well as performance returns since October 14th.  The rankings are based on projected performance by asset class and total.  

Here are a few takeaways about performance during QE4 thus far:

  • Value is outperforming growth by 1.67% (5.95% vs. 4.28%)
  • There is general uniformity amongst the equity indexes
  • Equity indices have captured at least 50%, and in the case of value and large caps (S&P 100) over 100% of the expected gains, despite being only one-sixth of the way through QE4
  • The sharp variation in sector returns is contradictory to the relatively consistent returns at the index level
  • Discretionary stocks are trading poorly when compared to other sectors and to the expected performance forecast for discretionary stocks
  • Defensive sectors are trading relatively weaker as occurred during prior QE
  • The healthcare sector has been the best performing sector within the S&P as well as versus every index and commodity in the tables
  • The yield curve steepened as expected
  • In the commodity sector, precious metals are weaker, but oil and copper are positive

Are Adjustments to QE4 Coming?

The Fed has recently made public statements that lead us to believe they are concerned with rising debt levels. In particular, a few Fed speakers have noted the sharp rise in corporate and federal debt levels both on an absolute basis and versus earnings and GDP. The increase in leverage is made possible in part by low interest rates and QE. In addition, some Fed speakers over the last year or two have grumbled about higher than normal equity valuations.

It was for these very reasons that in 2013, Jerome Powell voiced concerns about the consequences of asset purchases (QE). To wit: 

“What of the potential costs or risks of the asset purchases? A variety of concerns have been raised over time. With inflation in check, the most important potential risk, in my view, is that of financial instability. One concern is that our policies might drive excessive risk-taking or create bubbles in financial assets or housing.”

Earlier this month, Jerome Powell, in Congressional testimony said:

“The debt is growing faster than the economy. It’s as simple as that. That is by definition unsustainable. And it is growing faster in the United States by a significant margin.”

With more leverage in the financial system and higher valuations in the equity and credit markets, how does Fed Chairman Powell reconcile those comments with where we are today? It further serves to highlight that political expediency has thus far trumped the long-run health of the economy and the financial system.

Based on the Fed’s prior and current warnings about debt and valuations, we believe they are trying to fix funding issues without promoting greater excesses in the financial markets. To thread this needle, they must supply just enough liquidity to restore financing markets to normal but not over stimulate them. This task is much easier said than done due to the markets’ Pavlovian response to QE.

Where the fed funds effective rate sits within the Fed’s target range can be a useful gauge of the over or undersupplying of liquidity. Based on this measure, it appears the Fed is currently oversupplying liquidity as seen in the following chart. For the first time in at least two years, as circled, the effective Fed Funds rate has been consistently below the midpoint of the Fed’s target range.

If the Fed is concerned with debt levels and equity valuations and is comfortable that they have provided sufficient liquidity, might they halt QE4, reduce monthly amounts, or switch to a more flexible model of QE?

We think all of these options are possible.

Any effort to curtail QE will be negative for markets that have been feasting on the additional liquidity. Given the symbiotic relationship between markets and QE, the Fed will be cautious in making changes. As always, the first whisper of change could upset the apple cart.

Summary

Equity markets have been rising on an almost daily basis despite benign economic reports, negative trade and tariff headlines, and Presidential impeachment proceedings, among other worrisome factors. We have little doubt that investors have caught QE fever again, and they are more concerned with the FOMO than fundamentals.

As the fresh round of liquidity provided by the Fed leaks into the markets, it only further advances more misallocation of capital, such as excessive borrowing by zombie companies and borrowing to further fund unproductive stock buybacks. Like dogs drooling at the sound of a ringing bell, most investors expect the bull run to continue. It may, but there is certainly reason for more caution this time around as the contours of the economy and the market are vastly different from prior rounds. Add to this the incoherence of this policy action in light of the record expansion, benign inflation readings, and low unemployment rate and we have more questions about QE4 than feasible answers.

To Buy, Or Not To Buy- An Investors Guide to QE 4

In no sense is this QE” – Jerome Powell

On October 9, 2019, the Federal Reserve announced a resumption of quantitative easing (QE). Fed Chairman Jerome Powell went to great lengths to make sure he characterized the new operation as something different than QE. Like QE 1, 2, and 3, this new action involves a series of large asset purchases of Treasury securities conducted by the Fed. The action is designed to pump liquidity and reserves into the banking system.

Regardless of the nomenclature, what matters to investors is whether this new action will have an effect on asset prices similar to prior rounds of QE. For the remainder of this article, we refer to the latest action as QE 4.

To quantify what a similar effect may mean, we start by examining the performance of various equity indexes, equity sectors, commodities, and yields during the three prior QE operations. We then normalize the data for the duration and amount of QE to project what QE 4 might hold in store for the assets.

Equally important, we present several factors that are unique to QE 4 and may result in different outcomes. While no one has the answers, we hope that the quantitative data and the qualitative commentary we provide arms you with a better appreciation for asset return possibilities during this latest round of QE. 

How QE 1, 2, and 3 affected the markets

The following series of tables, separated by asset class, breaks down price performance for each episode of QE. The first table for each asset class shows the absolute price return for the respective assets along with the maximum and minimum returns from the start of each QE. The smaller table below it normalizes these returns, making them comparable across the three QE operations. To normalize the data, we annualize the respective QE returns and then scale the returns per $100 billion of QE. For instance, if the S&P 500 returned 10% annualized and the Fed bought $500 billion of assets during a particular QE, then the normalized return would be 2% per $100 billion of QE.

Data in the tables are from Bloomberg.  Click on any of the tables to enlarge.

QE 4 potential returns

If we assume that assets will perform similarly under QE 4, we can easily forecast returns using the normalized data from above. The following three tables show these forecasts. Below the tables are rankings by asset class as well as in aggregate. For purposes of this exercise, we assume, based on the Fed’s guidance, that they will purchase $60 billion a month for six months ($360 billion) of U.S. Treasury Bills.

Takeaways

The following list provides a summarization of the tables.

  • Higher volatility and higher beta equity indexes generally outperformed during the first three rounds of QE.
  • Defensive equity sectors underperformed during QE.
  • On average, growth stocks slightly outperformed value stocks during QE. Over the last decade, inclusive of non-QE periods, growth stocks have significantly outperformed value stocks.
  • Longer-term bond yields generally rose while shorter-term yields were flat, resulting in steeper yield curves in all three instances. 
  • Copper, crude oil, and silver outperformed the S&P 500, although the exceptional returns primarily occurred during QE 1 for copper and crude and QE 1 and 2 for Silver.
  • On a normalized basis, Silver’s 10.17% return per $100bn in QE 2, is head and shoulders above all other normalized returns in all three prior instances of QE.
  • In general, assets were at or near their peak returns as QE 1 and 3 ended. During QE 2, a significant percentage of early gains were relinquished before QE ended.
  • QE 2 was much shorter in duration and involved significantly fewer purchases by the Fed.
  • The expected top five performers during QE4 on a normalized basis from highest to lowest are: Silver, S&P 400, Discretionary stocks, S&P 600, and Crude Oil. 
  • Projected returns for QE 4 are about two-thirds lower than the average of prior QE. The lesser expectations are, in large part, a function of our assumption of a smaller size for QE4. If the actual amount of QE 4 is larger than current expectations, the forecasts will rise.

QE, but in a different environment

While it is tempting to use the tables above and assume the future will look like the past, we would be remiss if we didn’t point out that the current environment surrounding QE 4 is different from prior QE periods. The following bullet points highlight some of the more important differences.

  • As currently planned, the Fed will only buy Treasury Bills during QE 4, while the other QE programs included the purchase of both short and long term Treasury securities as well as mortgages backed securities and agency debt. 
  • Fed Funds are currently targeted at 1.75-2.00%, leaving the Fed multiple opportunities to reduce rates during QE 4. In the other instances of QE, the Fed Funds rate was pegged at zero. 
  • QE 4 is intended to provide the banking system needed bank reserves to fill the apparent shortfall evidenced by high overnight repo funding rates in September 2019. Prior instances of QE, especially the second and third programs, supplied banks with truly excess reserves. These excess reserves helped fuel asset prices.
  • Equity valuations are significantly higher today than during QE 1, 2, and 3.
  • The amount of government and corporate debt outstanding is much higher today, especially as compared with the QE 1 and 2 timeframes.
  • Having achieved a record-breaking duration, the current economic expansion is old and best described as “late-cycle”.

Déjà vu all over again?

The prior QE operations helped asset prices for three reasons.

  • The Fed removed a significant amount of securities from the market, which forced investors to buy other assets. Because the securities removed were the least risky available in the market, investors, in general, moved into riskier assets. This had a circular effect pushing investors further and further into riskier assets.
  • QE 4 appears to be providing the banks with needed reserves. Assuming that true excess reserves in the system do not rise sharply, as they did in prior QE, the banks will probably not use these reserves for proprietary trading and investing. 
  • Because the Fed is only purchasing Treasury Bills, the boost of liquidity and reserves is relatively temporary and will only be in the banking system for months, not years or even decades like QE 1, 2, and 3.

Will QE 4 have the same effect on asset prices as QE 1, 2, and 3?

Will the bullish market spirits that persisted during prior episodes of QE emerge again during QE 4?

We do not have the answers, but we caution that this version of QE is different for the reasons pointed out above. That said, QE 4 can certainly morph into something bigger and more akin to prior QE. The Fed can continue this round beyond the second quarter of 2020, an end date they provided in their recent announcement. They can also buy more securities than they currently allude to or extend their purchases to longer maturity Treasuries or both. If the economy stumbles, the Fed will find the justification to expand QE4 into whatever they wish.

The Fed is sensitive to market returns, and while they may not want excessive valuations to keep rising, they will do anything in their power to stop valuations from returning to more normal levels. We do not think investors can blindly buy on QE 4, as the various wrinkles in Fed execution and the environment leave too many unanswered questions. Investors will need to closely follow Fed meetings and Fed speakers for clues on expectations and guidance around QE 4.

The framework above should afford the basis for critical evaluation and prudent decision-making. The main consideration of this analysis is the benchmark it provides for asset prices going forward. Should the market disappoint despite QE 4 that would be a critically important contrarian signal.

QE By Any Other Name

“What’s in a name? That which we call a rose, By any other name would smell as sweet.” – Juliet Capulet in Romeo and Juliet by William Shakespeare

Burgeoning Problem

The short-term repo funding turmoil that cropped up in mid-September continues to be discussed at length. The Federal Reserve quickly addressed soaring overnight funding costs through a special repo financing facility not used since the Great Financial Crisis (GFC). The re-introduction of repo facilities has, thus far, resolved the matter. It remains interesting that so many articles are being written about the problem, including our own. The on-going concern stems from the fact that the world’s most powerful central bank briefly lost control over the one rate they must control.

What seems clear is the Fed measures to calm funding markets, although superficially effective, may not address a bigger underlying set of issues that could reappear. The on-going media attention to such a banal and technical topic could be indicative of deeper problems. People who understand both the complexities and importance of these matters, frankly, are still wringing their hands. The Fed has applied a tourniquet and gauze to a serious wound, but permanent medical attention is still desperately needed.

The Fed is in a difficult position. As discussed in Who Could Have Known – What the Repo Fiasco Entails, they are using temporary tools that require daily and increasingly larger efforts to assuage the problem. Taking more drastic and permanent steps would result in an aggressive easing of monetary policy at a time when the U.S. economy is relatively strong and stable, and such policy is not warranted in our opinion. Such measures could incite the most underrated of all threats, inflationary pressures.

Hamstrung

The Fed is hamstrung by an economy that has enjoyed low interest rates and stimulative fiscal policy and is the strongest in the developed world. By all appearances, the U.S. is also running at full employment. At the same time, they have a hostile President sniping at them to ease policy dramatically and the Federal Reserve board itself has rarely seen internal dissension of the kind recently observed. The current fundamental and political environment is challenging, to be kind.

Two main alternatives to resolve the funding issue are:

  1. More aggressive interest rate cuts to steepen the yield curve and relieve the banks of the negative carry in holding Treasury notes and bonds
  2. Re-initiating quantitative easing (QE) by having the Fed buy Treasury and mortgage-backed securities from primary dealers to re-liquefy the system

Others are putting forth their perspectives on the matter, but the only real “permanent” solution is the second option, re-expanding the Fed balance sheet through QE. The Fed is painted into a financial corner since there is no fundamental justification (remember “we are data-dependent”) for such an action. Further, Powell, when asked, said they would not take monetary policy actions to address the short-term temporary spike in funding. Whether Powell likes it or not, not taking such an action might force the need to take that very same action, and it may come too late.

Advice from Those That Caused the Problem

There was an article recently written by a former Fed official now employed by a major hedge fund manager.

Brian Sack is a Director of Global Economics at the D.E. Shaw Group, a hedge fund conglomerate with over $40 billion under management. Prior to joining D.E. Shaw, Sack was head of the New York Federal Reserve Markets Group and manager of the System Open Market Account (SOMA) for the Federal Open Market Committee (FOMC). He also served as a special advisor on monetary policy to President Obama while at the New York Fed.

Sack, along with Joseph Gagnon, another ex-Fed employee and currently a senior fellow at the Peterson Institute for International Economics, argue in their paper LINK that the Fed should first promptly establish a standing fixed-rate repo facility and, second, “aim for a higher level of reserves.” Although Sack and Gagnon would not concede that reserves are “low”, they argue that whatever the minimum level of reserves may be in the banking system, the Fed should “steer well clear of it.” Their recommendation is for the Fed to increase the level of reserves by $250 billion over the next two quarters. Furthermore, they argue for continued expansion of the Fed balance sheet as needed thereafter.

What they recommend is monetary policy slavery. No matter what language they use to rationalize and justify such solutions, it is pure pragmatism and expediency. It may solve short-term funding issues for the time being, but it will leave the U.S. economy and its citizens further enslaved to the consequences of runaway debt and the monetary policies designed to support it.

If It Walks and Quacks Like a Duck…

Sack and Gagnon did not give their recommendation a sophisticated name, but neither did they call it “QE.” Simply put, their recommendation is in fact a resumption of QE regardless of what name it is given.

To them it smells as sweet as QE, but the spin of some other name and rationale may be more palatable to the public. By not calling it QE, it may allow the Fed more leeway to do QE without being in a recession or bringing rates to near zero in attempts to avoid becoming a political lightening rod.

The media appears to be helping with what increasingly looks like a sleight of hand. Joe Weisenthal from Bloomberg proposed the following on Twitter:

To help you form your own opinion let’s look at some facts about QE and balance sheet increases prior to the QE era. From January of 2003 to December of 2007, the Fed’s balance sheet steadily increased by $150 billion, or about $30 billion a year. The new proposal from Sack and Gagnon calls for a $250 billion increase over six months. QE1 lasted six months and increased the Fed’s balance sheet by $265 billion. Maybe its us, but the new proposal appears to be a mirror image of QE.

Summary

The challenge, as we see it, is that these former Fed officials do not realize that the policies they helped create and implement were a big contributor to the financial crisis a decade ago. The ensuing problems the financial system is now enduring are a result of the policies they implemented to address the crisis. Their proposed solutions, regardless of what they call them, are more imprudent policies to address problems caused by imprudent policies since the GFC.

Who Could Have Known: What The Repo Fiasco Entails

Imagine approaching a friend that you think is very wealthy and asking her to borrow ten thousand dollars for just one night. To entice her, you offer as collateral the title to your 2019 Lexus parked in her driveway along with an interest rate that is 5% above that which she is earning in the bank. Shockingly, your friend says she can’t. Given the risk-free nature of the transaction and excellent one-day profit, we can assume that our friend may not be as wealthy as we thought.

On Monday, September 16th, 2019, a similar situation occurred in the overnight repurchase agreement (repo) funding market. On that day, banks were unwilling or unable to lend on a collateralized basis, even with the promise of large risk-free profits. This behavior reveals something very important about the banking system and points to the end of market stimulus that has been around for the past decade.

The Plumbing of the Banking System and Financial Markets

Interbank borrowing is the engine that allows the financial system to run smoothly. Banks routinely borrow and lend to each other on an overnight basis to ensure that all banks have ample funds to meet daily cash flow needs and that banks with excess funds can earn interest on them. Literally, years go by with no problems in the interbank markets and not a mention in the media.

Before proceeding, what follows is a definition of the funding instruments used in the interbank markets.

  • Fed Funds are uncollateralized interbank loans that are almost exclusively done on an overnight basis. Except for a few exceptions, only banks can trade Fed Funds.
  • Repo (repurchase agreements) are collateralized loans. These transactions occur between banks but often involve other non-bank financial institutions such as insurance companies. Repo can be negotiated on an overnight and longer-term basis. General collateral, or “GC,” is a term used to describe Treasury, agency, and mortgage collateral that backs certain repo loans. In a GC repo, the particular securities backing the loan are not determined until after the transaction is agreed upon by the counterparties. The securities delivered must meet certain pre-defined criteria.

On September 16th, overnight GC repo traded as high as 8%, almost 6% higher than the Fed Funds rate, which theoretically should keep repo and other money market rates closely tied to it. The billion-dollar question is, “Why did a firm willing to pay a hefty premium, with risk-free collateral, struggle to borrow money”?  Before the 16th, a premium of 25 to 50 basis points versus Fed Funds would have enticed a mob of financial institutions to lend money via the repo markets. On the 16th, many multiples of that premium were not enticing enough.

Most likely, there was an unexpected cash crunch that left banks and/or financial institutions underfunded. The media has talked up the corporate tax date and a large Treasury bond settlement date as potential reasons. We are not convinced by either excuse as they were easily forecastable weeks in advance.

Regardless of what caused the liquidity crunch, we do know, that in aggregate, banks did not have the capacity to lend money. Given the capacity, they would have done so in a New York minute and at much lower rates.

To highlight the enormity of the aberration, consider the following:

  • Since 2006, the average daily difference between the overnight GC repo rate and the Fed Funds effective rate was .025%.
  • Three standard deviations or 99.5% of the observances should have a spread of .56% or less.
  • 8% is a bewildering 42 standard deviations from the average, or simply impossible assuming a traditional bell curve.

What was revealed on the 16th?

The U.S. and global banking systems revolve around fractional reserve banking. That means banks need only hold a fraction of the cash deposits that they hold in reserve accounts at the Fed. For example, if a bank has $1,000 in deposits (a liability to the bank), they may lend $900 of those funds and retain only 10% in reserves. This is meant to ensure they have enough funding on hand to make payments during the day and also as a buffer against unanticipated liquidity needs. Before 2008, banks held only just as many reserves as were required by the Fed. Holding anything more than the required minimum was a drag on earnings, as excess reserves were unremunerated at the time.

Quantitative Easing (QE) and the need for the Fed to pay interest on newly formed excess reserves changed that. When the Fed conducted QE, they bought U.S. Treasury, agency, and mortgage-backed securities and credited the selling bank’s reserve account. The purpose of QE1 was to ensure that the banking system was sufficiently liquid and equipped to deal with the ramifications of the ongoing financial crisis. Round one of QE was logical given the growing list of bank/financial institution failures. However, additional rounds of QE appear to have had a different motive and influence as banks were highly liquid after QE1 and had shored up their capital as well. That is a story for another day.

The graph below shows how “excess” reserves were close to zero before 2008 and soared by over $2.5 trillion after the three rounds of QE. Before QE, “excess” reserves were tiny, measured in the hundreds of millions. The amount is so small it is not visible on the graph below. The reserves produced by multiple rounds of quantitative easing may have been truly excess, meaning above required reserves, on day one of QE. However, on day two and beyond that is not necessarily true for any particular bank or the system as a whole, as we are about to explain.

Data courtesy: St. Louis Federal Reserve

The Fed, having pushed an enormous amount of reserves on the banks, created a potential problem. The Fed feared that once the smoke cleared from the financial crisis, banks would revert to their pre-crisis practice of keeping only the minimum amount of reserves required. This would leave them an unprecedented surplus of excess funds to buy financial assets and/or create loans which would vastly increase the money supply with inflationary consequences. To combat this problem, they incentivized the banks to keep the reserves locked down by paying them a rate of interest on the reserves that were higher than the Fed funds rates and other prevailing money market rates. This rate is called the IOER or the interest on excess reserves.

The Fed assumed banks would hold excess reserves because they could make risk free profits at no cost. This largely worked, but some reserves were leveraged by the banks and flowed into the financial markets. This was a big factor in driving stock prices higher, credit spreads tighter, and bond yields lower. This form of inflation the Fed seemed to desire as evidenced from their many speeches talking about generating household net worth.

From the banks’ perspective, the excess reserves supplied by the Fed during QE were preferential to traditional uses of excess reserves. Historically, excess bank reserves were invested in the Treasury market or lent on to other banks in the Fed Funds market. Purchasing Treasury securities had no credit risk, but banks are required to mark their Treasury holdings to market and therefore produce unexpected gains and losses. Lending reserves in the interbank market also incurred counterparty risk, as there was always the chance the borrowing bank would be unable to repay the loan, especially in the immediate post-crisis period. Additionally, as QE had produced trillions in excess reserves, there was not much demand from other banks. Therefore, the banks preferred use of excess reserves was leaving them on deposit with the Fed to earn IOER. This resulted in no counterparty risk and no mark to market risk.

Beginning in 2018, the Fed began reducing their balance sheet via QT and the amount of excess reserves held by banks began to decline appreciably.

Solving Our Mystery

It is nearly impossible for the public to figure out how much in excess reserves the banking system is truly carrying. Indeed, even the Fed seems uncertain. It is common knowledge that they have been declining, and over the last six months, clues emerged that the amount of “truly excess reserves,” meaning the amount banks could do without, was possibly approaching zero.  

Clue one came on March 20th, 2019 when the Fed said QT would end in October 2019. Then, on July 31st, 2019, as small problems occurred in the funding markets, the Fed abruptly announced that they would halt the balance sheet reduction in August, two months earlier than originally planned. The QT effort, despite assurances from Bernanke, Yellen, and Powell that it would be uneventful, ended 22 months after it began. The Fed’s balance sheet declined only $800 billion as a result of QT, less than a quarter of what the Fed added to their balance sheet during QE.

Clue two was the declining spread between the IOER rate and the effective Fed Funds rate as the level of excess reserves was declining, as seen in the chart below. The spread between IOER and the Fed Funds rate was narrowing because the Fed was having trouble maintaining the Fed Funds rate within the targeted range. In March 2019, the spread became negative, which was counter to the Fed’s objectives. Not surprisingly, this is when the Fed first announced that QT would end.

Data courtesy: St. Louis Federal Reserve

The third and final clue emerged on September 16, 2019, when overnight repo traded at 7%-8%. If banks truly had excess reserves, they would have lent some of that excess into the repo market and rates would never have gotten close to 7-8%. It seems logical that banks would have been happy to lend on a collateralized basis at 3%, much less 7-8%, when their alternative, leaving excess reserves to the Fed, would have earned them 2.25%.   

Further confirmation that something was amiss occurred on September 17th, 2019, when the Fed Funds effective rate was above the upper end of the Fed’s target range of 2-2.25% at the time. This marked the first time the Fed Funds rate traded above its target since 2008.

On September 17th, the Fed entered the repo markets with a $53 billion overnight repo operation, whereby banks could pledge Treasury collateral to the Fed and receive cash. The temporary liquidity injection worked and brought repo rates back to normal. The following day the Fed pumped $75 billion into the markets. These were the first repo transactions executed by the Fed since the Financial Crisis, as shown below.

These liquidity operations will likely continue as long as there is demand from banks. The Fed will also conduct longer-term repo operations to reduce the amount of daily liquidity they provide.

The Fed can continue to resort to the pre-QE era tactics and use temporary daily operations to help target overnight borrowing rates. They can also reduce the reserve requirements which would, at least for some time, provide the system with excess reserves. Lastly, they can permanently add reserves with QE. Recent rhetoric from Fed Chairman Powell and New York Fed President Williams suggests a resumption of QE in some form may be closer than we think.

Why should we care?

The QE-related excess reserves were used to invest in financial assets. While the investments were probably high-grade liquid assets, they essentially crowded out investors, pushing them into slightly riskier assets. This domino effect helped lift all asset prices from the most risk-free and liquid to those that are risky and illiquid. Keep in mind the Fed removed about $3.6 trillion of Treasury and mortgage securities from the market which had a similar effect.

The bottom line is that the role excess reserves played in stimulating the markets over the last decade is gone. There are many other factors driving asset prices higher such as passive investing, stock buybacks, and a broad-based, euphoric investment atmosphere, all of which are byproducts of extraordinary monetary policies. The new modus operandi is not necessarily a cause for concern, but it does present a new demand curve for the markets that is different from what we have become accustomed to.

Summary

Short-term funding is never sexy and rarely if ever, the most exciting part of the capital markets. A brief recollection of 2008 serves as a reminder that, when it is exciting, it is usually a harbinger of volatility and disruption.

In a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.”

Much more recently, Jay Powell stated, “We’ve been operating in this regime for a full decade. It’s designed specifically so that we do not expect to be conducting frequent open market operations to keep fed fund [sic] rates in the target range.” 

Today, a decade after the financial crisis, we see that Bernanke and Powell have little appreciation for the inner-workings of the financial system. 

In the Wisdom of Peter Fisher, an RIA Pro article released in July, we discussed the insight of Peter Fisher, a former Treasury, and Federal Reserve official. Unlike most other Fed members and politicians, he discussed how hard getting back to normal will be. As we are learning, it turns out that Fisher’s wisdom from 2017 was visionary.

“As Fisher stated in his remarks, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.”

Prophetic indeed.

The Wisdom of Peter Fisher

“In recent years, numerous major central banks announced objectives of achieving more rapid rates of inflation as strategies for fostering higher standards of living. All of them have failed to achieve their objectives.” – Jerry Jordan, former Cleveland Federal Reserve Bank President

In March 2017, former Treasury and Federal Reserve (Fed) official, Peter R. Fisher, delivered a speech at the Grant’s Interest Rate Observer Spring Conference entitled Undoing Extraordinary Monetary Policy. It is one of the most insightful and compelling assessments of the Fed’s post-financial crisis policy actions available.

Now a professor at the Tuck School of Business at Dartmouth, Fisher is a true insider with experience in the government and private sector that affords him unique insight. Given the recent policy “pivot” by Chairman Powell and all members of the Fed, Fisher’s comments from two years ago take on fresh relevance worth revisiting.

In the past, when Fed leadership discussed normalizing the Fed’s post-crisis policy actions, they exuded confidence that it can and will be done smoothly and without any implications for the economy or markets. Specifically, in a Washington Post article from 2010, Bernanke stated, “We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.” More recently, Janet Yellen and others have echoed those sentiments. Current Fed Chairman Jerome Powell, tasked with normalizing policy, appears to be finding out differently.

Define “Normal”

Taking a step back, there are important issues at stake if the Fed truly wants to unshackle the market economy from the influences of extreme monetary policy and the harm it may be causing. To normalize policy, the Fed first needs to explicitly define “normal.”

For instance:

  • The Fed should take steps to raise interest rates to what is considered “normal” levels. Normal can be characterized as a Federal Funds target rate in line with the average of the past 30 years or it might be a level that reflects sufficient “dry powder” were the Fed to need that policy tool in a future economic slowdown.
  • The Fed should reduce the size of their balance sheet. In this case, normal under reasonable logic would be the size of the balance sheet before the financial crisis either in absolute terms or as a percentage of nominal gross domestic production (GDP). Despite some reductions, it is not close on either count.

The Fed consistently feeds investors’ guessing games about what they deem appropriate. There appears to be little rigor, debate, or transparency about the substance of those decisions. Neither Ben Bernanke nor Janet Yellen offered details about how they would accurately characterize “normal” in either context. The reason for this seems obvious enough. If they were to establish reasonable parameters that defined normal levels in either case, they would be held accountable for differences from their prescribed benchmarks. It might force them to take actions that, while productive and proper in the long-run, may be disruptive to the financial markets in the short run. How inconvenient.

In most instances, normal is defined as something that conforms to a standard or that which has been common under historical experience. Begin by looking at the Fed Funds target rate. A Fed Funds rate of 0.0% for seven years is not normal, nor is the current rate range of 2.25-2.50%.

As illustrated in the chart below, in each of the past three recessions dating back to 1989, the Fed cut the fed funds rate by an average of 5.83%. In that context, and now resting at less than half the average historical pre-recession level, a Fed Funds rate of 2.25-2.50% is clearly abnormal and of greater concern, insufficient to combat a downturn.

Interest rates should mimic the structural growth rate of the economy. As we have illustrated in prior analysis and articles, particularly Wicksell’s Elegant Model, using a 7-year cycle for economic growth reflective of historical expansions, that time-frame should offer a reasonable proxy for “structural” economic growth. The issue of greater concern is that, contrary to the statement above, structural growth appears to be imitating the level of interest rates meaning the more the Fed suppresses interest rates, the more growth languishes.

Next, let’s look at the Fed balance sheet. Quantitative tightening began in late 2017 gradually increasing as the Fed allowed their securities bought during QE to mature without replacing them. As shown in the blue shaded area in the chart below, QT reduced the Fed balance sheet by about $500 billion, but it remains absurdly high at nearly $4.0 trillion. As a percentage of GDP, it has dropped from a peak of 25.3% to 19%. Before the point at which QE was initiated in September 2008, the size of the Fed balance sheet was roughly $900 billion or 6% of nominal GDP and was in a tight range around that level for decades. Now, with the Fed halting any further reductions in the balance sheet, are we to assume 20% of GDP to be a normal level? If so, what is the basis for that conclusion?

The bottom line: simple analysis, straight-forward logic, and common sense dictate that monetary policy remains abnormal.

Fisher helps us understand why the Fed is so hesitant to normalize policy, despite their outward confidence in being able to do so.

Second-Order Effects

As Fisher stated in his remarks at the conference, The challenge of normalizing policy will be to undo bad habits that have developed in how monetary policy is explained and understood.” This is a powerfully important statement highlighting second-order effects. He continues, “…the Fed will have to walk back from their early assurances that the “exit would be easy.” Prophetic indeed.

The “easy” part of getting rates and the balance sheet back to “normal” is now proving to be not so easy. What the Fed did not account for when they unleashed unprecedented policy was the habits and behaviors among governments, corporations, households, and investors. Modifying these behaviors will come at a debilitating cost.

Think of it like this: Nobody starts smoking cigarettes with a goal of smoking two packs a day for 30 years, but once introduced, it is difficult to stop. Furthermore, trying to stop smoking can be very painful and expensive. NOT stopping is medically and scientifically proven to be even more so.

Fisher goes on to explain in real-world terms how two households are impacted in an environment of extraordinary policy actions. One household possesses savings; the other does not. Consider their traditional liabilities such as mortgage and auto loans, “but also their future consumption expenditures, their liability to feed and clothe themselves in the future.” The family with savings may feel wealthier from gains in their invested savings and retirement accounts as a result of extraordinary policies pushing financial markets higher, but they also must endure an increase in the cost of living. In the final analysis, they end up where they started. “They may… perceive a wealth effect but, ultimately, there is only a wealth illusion.”

As for the family without savings, they had no investments to go up in value, so there is no wealth effect. This means that their cost of living rose and, wages largely stagnant, it occurred without any form of a commensurate rise in income. That can only mean their standard of living dropped. As Fisher states, given extraordinary policy imposed, “There was no wealth effect, not even a wealth illusion, just a cruel hoax.” He further adds, “…the next time you hear that the net-wealth of American households is at an all-time high, do spend a minute thinking about the present value of the unrecorded future consumption expenditures, particularly of households with no savings.”

What is remarkable about Fisher’s analysis is contrasting it with the statements of Fed officials who say they are acting in the best interest of all U.S. citizens. Quoting from George Orwell’s Animal Farm, “All animals are equal, but some animals are more equal than others.”

A man can easily drown crossing a stream that is on average 3 feet deep. Household wealth as a macro measure of monetary policy success in a period when wealth inequality is at such extremes perfectly illustrates this imperfection. As Fisher states, “Out of both humility and self-preservation, let’s hope the Fed finds a way to stop targeting the level of wealth.”

Linear Extrapolation

Fisher also addresses the issue of Fed forward guidance stating, “Implicit in forward guidance…is the idea that dampening short-term market uncertainty and volatility is a good thing. But removing uncertainty from our capital markets is not, in my view, an unambiguous blessing.”

Forward guidance, whereby the Fed provides expectations about future policy, targets an optimal level of volatility without being clear about what “optimal” means. How does the Fed know what is optimal? As we have stated before, a market made up of millions of buyers and sellers is a much better arbiter of prices, value, and the resulting volatility than is the small group of unelected officials at the Fed. Yet, they do indeed falsely portray an understanding of “optimal” by managing the prices of interest rates but theirs is a guess no better than yours or mine. Based upon their economic track record, we would argue their guess is far worse.

Fisher goes on to reference John Maynard Keynes on the subject of extrapolative expectations which is commonly used as a basis for asset pricing. Referring to it as the “conventional valuation” in his book The General Theory of Employment, Interest and Money, Keynes said this reflects investors’ assumptions “that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change.” Connecting those dots, Fisher states that “forward guidance is the process through which the Fed – through its more explicit influence on the expected rate of interest – becomes the much more explicit owner of the “conventional valuation” of asset prices… the Fed now has a heightened responsibility and sensitivity to asset pricing.

That conclusion is critically important and clarifies the behavior we see coming out of the Eccles Building. In becoming the “explicit owner” of valuations in the stock market, the Fed now must adhere to a pattern of decisions and actions that will ultimately support the prices of risky assets under all circumstances. Far from rigorous scrutiny of doubts and assumptions, the Fed fails in every way to apply the scientific method of analyzing their actions before and after they take them. So desperate are they to manage the expectations of the public, their current posture leaves no latitude for uncertainty. As Fisher further points out, the last time we saw evidence of a similar stance was in 2007 when the Fed rejected the possibility of a nation-wide decline in house prices.

Summary

Fisher fittingly sums up by restating the point he made at the beginning:

“…the Fed and other central banks appear to have avoided being candid about the uncertainty (of extraordinary monetary policies) in order to maintain their credibility. But this is backwards. They cannot regain their credibility unless they are candid about the uncertainty and how they confront it.”

The power of Fisher’s perspectives is in his candor. Now at a time when the Fed is proving him correct on every count, it is worthwhile to refresh our memories. We would encourage investors to read the transcript in full. Given the clarity of the insights he shares, summarized here, their importance cannot be overstated.

Undoing Extraordinary Monetary Policy

Investors Are Grossly Underestimating The Fed – RIA Pro UNLOCKED

 If you think the Fed may only lower rates by .50 or even .75, you may be grossly underestimating them.  The following article was posted for RIA Pro subscribers two weeks ago.

For more research like this as well as daily commentary, investment ideas, portfolios, scanning and analysis tools, and our new 401K manager sign up today at RIA Pro and test drive our site for 30 days before being charged.


Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

Are Fireworks Coming July 31st?

As a portfolio manager and fiduciary, it is vital that we constantly assess the risks to our market and economic forecasts. To better quantify risk we must frequently go a step further and understand where the markets may be neglecting to appreciate risk. While tricky, those that properly detect when the market is offside tend to either protect themselves and/or profit handsomely. It is with contrarian glasses on that we look beyond July 4th and towards July 31st for fireworks.

Through June the stock and bond markets priced in, with near certainty, a 50 basis point rate cut at the July 31, 2019, Federal Reserve FOMC meeting. In doing so, volatility in many markets could surge if the Fed does not follow the market’s lead.

Given this concern, we ask what might cause the Fed to disappoint the markets. We approach the answer from two angles, economic and political.

Economic

On the economic front, there are a growing number of indicators that point to slowing domestic economic growth. The following graph from Arbor shows seven important leading indicators (surveys and outlooks).

While the graph is concerning, hard economic data which tends to lag the survey data graphed above has yet to weaken to the same degree. If the weakening in the indicators graphed above prove to be a false signal or transitory, the Fed might cut rates less than expected or even delay taking policy actions.

A second reason the Fed might delay or not take action would be an increase in inflation expectations. The Fed has been outspoken about the need to bolster inflation expectations which have recently drifted lower. Given that unemployment is at 50 years lows and inflation close to their target, inflation expectations seems to be the rationale the Fed is using to justify action. If inflation expectations were to increase the Fed may not be able to defend reducing rates. The following events could temporarily increase inflation expectations:

  • Weaker dollar due to perceived easy monetary policy.
  • Iran tensions could push oil prices higher.
  • Excessive weather conditions in the Midwest are affecting consumer prices for certain commodities.
  • Tariffs are likely to increase prices paid by businesses and consumers.
  • Fed independence compromised (as discussed in the following paragraph).

Political

Beyond economics, politics is playing a role in the Fed’s thought process. The Fed was set up as an independent organization to insulate monetary policy from the often self-serving demands of the executive and legislative branches. Despite the Fed’s independence, many Presidents have bullied the Fed to take policy actions. Such tactics always occurred behind closed doors with the media and public having little idea that they were occurring.

Currently, President Trump is taking his criticism to the public airways and has gone as far as threatening to demote or fire Chairman Powell. A Fed Chairman has never been fired or demoted, leading many to question whether Trump has the legal authority to do so. The Federal Reserve Act states that the Chairman shall serve his stated term “unless sooner removed for cause by the President.” That sentence opens the door to much uncertainty under this President. The language is even less vague about demotion, which, in our opinion, is more likely.

If the Fed wants to assert its independence from the executive branch, they may be inclined to cut by 25 basis points or possibly not cut at all.  Anything short of a 50 basis point rate cut would inevitably irritate the President and increase the risk that Trump fires or demotes Powell. If such an unprecedented action were to transpire the markets would likely react violently. For more on how certain asset classes might perform in this scenario, please read our article Market Implications for Removing Fed Chair Powell.

Beyond the initial market responses to the news, a greater problem could arise. The peril of openly piercing the veil of independence at the Fed could impair many of the communication tools the Fed uses to influence policy and markets. In turn, the Fed will be limited in their ability to coax or pacify markets when needed.

While this spat may be brushed off as Beltway politics aired for the public in the Twittersphere and media, the consequences are large, and as such we must pay attention to this political soap opera.

Summary

We believe a 50 basis point cut is likely on July 31st and afterward the markets will renew their focus on the next few months and what that may have in store. However, unlike the vast majority, we believe that there are factors that may cause the Fed to sit on their hands. If the Fed disappoints the market, especially if not accompanied by warnings, the July fireworks this year may be coming 27 days late.

Market Implications For Removing Fed Chair Powell

  • John Kelly – White House Chief of Staff
  • James Mattis – Secretary of Defense
  • Jeff Sessions – Attorney General
  • Rex Tillerson – Secretary of State
  • Gary Cohn – Chief Economic Advisor
  • Steve Bannon – White House Chief Strategist
  • Anthony Scaramucci – White House Communications Director
  • Reince Priebus – White House Chief of Staff
  • Sean Spicer – White House Press Secretary
  • James Comey – FBI Director

Every week is shark week in the Trump White House,” wrote The Hill contributing author Brad Bannon in August of 2018.  A recent Brookings Institution study shows that the turnover in the Trump administration is significantly higher than during any of the previous five presidential administrations. The concern is that for a president without government experience, a rotating cast of top administration officials and advisors presents a unique challenge for the effective advancement of U.S. policies and global leadership. Bannon (no relation to former White House Chief Strategist Steve) adds, “Inexperience breeds incompetence.”

Although the sitting president has broken just about every rule of traditional politics, it is irresponsible and speculative to assume either ineffectiveness or failure by this one argument. One area of politics that falls within our realm of expertise is a “rule” that Donald Trump has not yet broken; firing the Chairman of the Federal Reserve.

Following the December Federal Open Market Committee (FOMC) meeting in which the Fed raised rates and the stock market fell appreciably, Bloomberg News reported that President Trump was again considering relieving the Fed Chairman of his responsibilities. This has been a continuing theme for Trump as his dissatisfaction with the Fed intensifies.

Not that Trump appears concerned about it, but firing a Fed Chairman is unprecedented in the 106-year history of the central bank. Having tethered all perception of success to the movements of the stock market, it is quite apparent why the president is unhappy with Jerome Powell’s leadership. Trump’s posture raises questions about whether he is more worried about his barometer of success (stock prices) or the long-term well-being of the economy. Acquiescing to either Trump or a genuine concern for the economic outlook, Chairman Powell relented in his stance on rate hikes and continuing balance sheet reduction.

Clamoring for Favor

Notwithstanding the abrupt reversal of policy stance at the Fed, President Trump continues to snipe at Powell and express dissatisfaction with what he considers to have been policy mistakes. Before backing out of consideration, Steven Moore’s nomination to the Fed board fits neatly with the points made above reflecting the President’s irritation with the Powell Fed. Moore was harshly critical of Powell and the Fed’s rate hikes despite a multitude of inconsistent remarks. Shortly after his nomination, Moore and the President’s Director at the National Economic Council, Larry Kudlow, stated that the Fed should immediately cut interest rates by 50 basis point (1/2 of 1%). Those comments came despite rhetoric from various fronts in the administration that the economy “has never been stronger.”

Now the Kudlow and Moore tactics are coming from within the Fed. St. Louis Fed President James Bullard dissented at the June 19th Federal Open Market Committee meeting in favor a rate cut. Then non-voting member and Minneapolis Fed President Neel Kashkari publicly stated that he was an advocate for a 50-basis point rate cut at the same meeting.

All this with unemployment at 3.6% and GDP tracking better than the 10-year average of 2.1%. Given Trump’s stated grievance with Powell, Bullard and Kashkari could easily be viewed as trying to curry favor with the administration. Even if that is not the case, to appear to be so politically inclined is very troubling for an institution and board members that must optically maintain an independent posture. It is unlikely that anyone has influence over Trump in his decision to replace or demote Powell. He will arrive at his conclusion and take action or not. If the first two years of his administration tells us anything, it is that public complaints about his appointed cabinet members precede their ultimate departure. Setting aside his legal authority to remove Powell, which would likely not stand in his way, the implications are what matter and they are serious.

For more on our thoughts on the ability of Trump to fire the Fed Chairman, please read our article Chairman Powell You’re Fired.

Prepare For This Tweet

Given Trump’s track record and his displeasure with Powell, we should prepare in advance for what could come as a surprise Tweet with little warning.

Ignoring legalities, if Trump were to demote or fire Powell, it is safe to assume he has someone in mind as a replacement. That person would certainly be more dovish and less prudent than Powell.

Under circumstances of a voluntary departure, a replacement with a more dovish disposition might be bullish for the stock market. However, the global economy is a complex system and there are many other factors to consider.

The first and largest problem is such a move would immediately erode the perception of Fed independence. Direct action taken to alter that independence would cast doubts on Fed credibility. Other sitting members of the Federal Reserve, appointed board members, and regional bank presidents, would likely take steps to defend the Fed’s independence and credibility which could create a functional disruption in the decision-making apparatus within the FOMC. Further, there might also be an active move by Congress to challenge the President’s decision to remove Powell. Although the language granting Trump the latitude to fire Powell is obtuse (he can be removed for “cause”), it is unclear that Presidential unhappiness affords him supportable justification. That would be an argument for the courts. Financial markets are not going to patiently await that decision.

With that in mind, what follows is an enumeration of possible implications for various key asset classes.

FX Markets

The most serious of market implications begin with the U.S. dollar (USD), the world’s reserve currency through which over 60% of all global trade transactions are invoiced.  The firing of Powell and the likely appointment of a Trump-friendly Chairman would drop the value of the USD on the expectations of a dovish reversal of monetary policy. The question of Fed independence, along with the revival of an easy money policy, would likely cause the dollar to fall dramatically relative to other key currencies. An abrupt move in the dollar would be highly disruptive on a global scale, as other countries would take action to stem the relative strength of their currencies versus the dollar and prevent weaker economic growth effects. The term “currency war” has been overused in the media, but in this case, it is the proper term for what would likely transpire.

Additionally, the weaker dollar and new policy outlook would heighten concerns about inflation. With the economy at or near full employment and most regions of the country already exhibiting signs of wage pressures, inflation expectations could spike higher.

Fixed Income

The bond market would be directly impacted by Fed turbulence. A new policy outlook and inflation concerns would probably cause the U.S. Treasury yield curve to steepen with 2-year Treasuries rallying on FOMC policy change expectations and 10-year and 30-year Treasury bond yields rising in response to inflation concerns. It is impossible to guess the magnitude of such a move, but it would probably be sudden and dramatic.

Indecision and volatility in the Treasury markets are likely to be accompanied by widening spreads in other fixed income asset classes.

Commodities

In the commodities complex, gold and silver should be expected to rally sharply.  While not as definitive, other commodities would probably also do well in response to easier Fed policy. A lack of confidence in the Fed and the President’s actions could easily result in economic weakness, which would lessen demand for many industrial commodities and offset the benefits of Fed policy changes.

Stock Market

The stock market response is best broken down into two phases. The initial reaction might be an extreme move higher, possibly a move of 8-10% or more in just a few days or possibly hours. However, the ensuing turmoil from around the globe and the potential for dysfunction within the Fed and Congress could cause doubt to quickly seep into the equity markets. Two things we know about equity markets is that they do not like changes in inflation expectations and they do not like uncertainty.

Economy

Another aspect regarding such an unprecedented action would be the economic effects of the firing of Jerome Powell. Economic conditions are a reflection of millions of households and businesses that make saving, investing, and consumption decisions on a day-to-day basis. Those decisions are dependent on having some certitude about the future.

If the disruptions were to play out as described, consumers and businesses would have reduced visibility into the future path for the economy. Questions about the global response, inflation, interest rates, stock, and commodity prices would dominate the landscape and hamstring decision-making. As a result, the volatility of everything would rise and probably in ways not observed since the financial crisis. Ultimately, we would expect economic growth to falter in that environment and for a recession to ensue.

Summary

Although economic growth has been sound and stocks are once again making record highs, the market and economic disruptions we have recently seen have been a long time coming. Market valuations across most asset classes have been engineered by excessive and imprudent monetary policy. The recent growth impulse is artificially high due to unprecedented expansion of government debt in a time of sound economic growth and low unemployment. In concert, excessive fiscal and monetary policy leave the markets and the economy vulnerable.

The evidence this year has been clear. Notwithstanding the Federal Reserve’s role in constructing this false reality, President Trump has not served the national interest well by his public criticism of the Fed. If Trump were to remove Powell as Fed chair, the prior sentence would be an understatement of epic proportions.

Investors Are Grossly Underestimating The Fed

Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.

The prospect of three 25 basis point rate cuts is hard to grasp given that the unemployment rate is at 50-year lows, economic growth has begun to slow only after a period of above-average growth, and inflation remains near the Fed’s 2% goal.  Interest rate markets are looking ahead and collectively expressing deep concerns based on slowing global growth, trade wars, and diminishing fiscal stimulus that propelled the economy over the past two years. Meanwhile, credit spreads and stock market prices imply a recession is not in the cards.

To make sense of the implications stemming from the Fed Funds futures market, it is helpful to assess how well the Fed Funds futures market has predicted Fed Funds rates historically. With this analysis, we can hopefully avoid getting caught flat-footed if the Fed not only lowers rates but lowers them more aggressively than the market implies.

Fed Funds vs. Fed Funds Futures

Before moving ahead, let’s define Fed Funds futures. The futures contracts traded on the Chicago Mercantile Exchange (CME), reflect the daily average Fed Funds interest rate that traders, speculator, and hedgers think will occur for specific one calendar month periods in the future. For instance, the August 2019 contract, trades at 2.03%, implying the market’s belief that the Fed Funds rate will be .37% lower than the current 2.40 % Fed Funds rate. For pricing on all Fed Funds futures contracts, click here.

To analyze the predictive power of Fed Funds futures, we compared the Fed Funds rate in certain months to what was implied by the futures contract for that month six months earlier. The following example helps clarify this concept. The Fed Funds rate averaged 2.39% in May. Six months ago, the May 2019 Fed Funds future contract traded at 2.50%. Therefore, six months ago, the market overestimated the Fed Funds rate for May 2019 by .11%. As an aside, the difference is likely due to the recent change in the Fed’s IOER rate.

It is important to mention that we were surprised by the conclusions drawn from our long term analysis of Fed Funds futures against the prevailing Fed Funds rate in the future.

The graph below tracks the comparative differentials (Fed Funds vs. Fed Fund futures) using the methodology outlined above. The gray rectangular areas represent periods where the Fed was systematically raising or lowering the Fed funds rate (blue line). The difference between Fed Funds and the futures contracts, colored green or red, calculates how much the market over (green) or under (red) estimated what the Fed Funds rate would ultimately be. In this analysis, the term overestimate means Fed Funds futures thought Fed Funds would be higher than it ultimately was. The term underestimate, means the market expectations were lower than what actually transpired.

To further help you understand the analysis we provide two additional graphs below, covering the most recent periods when the Fed was increasing and decreasing the Fed Funds rate.

Data Courtesy Bloomberg

Data Courtesy Bloomberg

Looking at the 2004-2006 rate hike cycle above, we see that the market consistently underestimated (red bars) the pace of Fed Funds rate increases.

Data Courtesy Bloomberg

During the 2007-2009 rate cut cycle, the market consistently thought Fed Funds rates would be higher (green bars) than what truly prevailed.

As shown in the graphs above, the market has underestimated the Fed’s intent to raise and lower rates every single time they changed the course of monetary policy meaningfully. The dotted lines highlight that the market has underestimated rate cuts by 1% on average, but at times during the last three rate-cutting cycles, market expectations were short by over 2%. The market has underestimated rate increases by about 35 basis points on average.

Summary

If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.

Heading into the financial crisis, it took the Fed 15 months to go from a 5.25% Fed funds rate to zero. Given their sensitivities today, how much faster might they respond to an economic slowdown or financial market dislocation from the current level of 2.25%?

We remind you that equity valuations are at or near record highs, in many cases surpassing those of the roaring 1920s and butting up against those of the late 1990s. If the Fed needs to cut rates aggressively, it will likely be the result of an economy that is heading into an imminent recession if not already in recession. With the double-digit earnings growth trajectory currently implied by equity valuations, a recession would prove extremely damaging to stock prices.

Treasury yields have fallen sharply recently across the entire curve. If the Fed lowers rates and is more aggressive than anyone believes, the likelihood of much lower rates and generous price appreciation for high-quality bondholders should not be underestimated.

The market has a long history of grossly underestimating, in both directions, what the Fed will do. The implications to stocks and bonds can be meaningful. To the extent one is inclined and so moved to exercise prudence, now seems to be a unique opportunity to have a plan and take action when necessary.

Chairman Powell – You’re Fired (Update)

Since President Trump first discussed firing Jerome Powell, out of a sense of frustration that his Fed Chair pick was not dovish enough, he has regularly expressed his displeasure at Powell’s lack of willingness to do whatever it takes to keep the economy booming beyond its potential. Strong economic growth serves Trump well as it boosts the odds of winning a second term.

This thought of firing the Fed Chair took an interesting turn yesterday when Mario Draghi, Jerome Powell’s counter-part in the ECB, commented that he was open to lowering interest rates and expanding quantitative easing measures if economic growth in the E.U. didn’t start to pick up soon.

This led to the following Trump tweet:

The bottom line is that the ECB will push Trump harder to lean on the Fed to be more aggressive with lower rates and QE. Trump’s urgency for Fed action also increases the odds that Powell could be replaced or demoted, as such a discussion was rumored to have been discussed. Look for fireworks on Trumps Twitter page today if the Fed does not take a dovish tact. We remind you:

“[Powell]’s my pick — and I disagree with him entirely,” Trump said last week in an interview with ABC News.

“Frankly, if we had a different person in the Federal Reserve that wouldn’t have raised interest rates so much we would have been at least a point and a half higher.”

The following article was published last October and is even more relevant today. If Powell becomes an impediment to aggressive Federal Reserve policy and therefore hurts Trump’s chances of winning in 2020, we might just see Chairman Powell get fired or demoted. Is that possible?


On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

Navigating With The R Star

“It’s difficult to make predictions, especially about the future.” – Niels Bohr

On November 28, 2018, Federal Reserve (Fed) Chairman Jerome Powell gave a speech at the Economics Club of New York that sent the stock market soaring by over 2%. The reason cited by market pundits was the reversal of language he used a few weeks earlier suggesting that the Fed still had several more rate hikes ahead. In other words, he softened that tone and seemed to imply that the Fed was close to pausing.

By most accounts, Fed policy remains very accommodative but the “Powell Pivot”, which began in late November and continues to this day, hinges on an obscure metric called R-Star (r*).  Even though interest rates have been held low and vast amounts of liquidity force fed into markets through quantitative easing, the idea that interest rates should not rise much further presents a unique dilemma for the Fed. Rationalizations for their guidance hinges on r*. Before going in to details about this important measure, let us reflect on history.

Doomed To Repeat It

“Well, we currently see the economy as continuing to grow, but growing at a relatively slow pace, particularly in the first half of this year. As the housing contraction begins to wane, as it should sometime during this fiscal year, the economy should pick up a bit later in the year. –Federal Reserve Chairman Ben Bernanke on January 17, 2008 in response to Congressman John Spratt ranking member of the House Budget Committee

The table below was a document used on an unscheduled Fed conference call on January 9, 2008 to discuss deteriorating credit conditions in the U.S. economy. At that time and unbeknownst to the Fed, the economy slipped into recession the prior month, yet the Fed’s commentary and one- and two-year outlook for growth remained positive. The point is not to deride Bernanke and the Fed, but show that even the most well-informed PhD economists struggle to forecast economic activity or assess current economic conditions properly.

The challenge in assessing the outlook for a highly complex system like the U.S. economy cannot be overstated. Yet, what we saw in the past and still see currently, is a small group of people with enormous influence over the economy failing to grasp the natural mechanisms of a market economy. To put it another way, the Fed continues to believe that they know things they simply cannot know, and most concerningly, they set monetary policy on the basis of that fallacy.

An Abstract Barometer

Over the past several years, Fed economists invented a concept that purportedly identifies the point at which monetary policy is “neutral” or in equilibrium with economic activity. This number, called r* (r-star), is abstract and imprecise as it requires a variety of assumptions about the level of interest rates and economic activity. R* is formally defined as the “inflation-adjusted, short-term interest rate that is consistent with the full use of economic resources and steady inflation at or near the Fed’s target level.

As discussed in Clues from the Fed II – A Review of Jerome Powell’s Speech 11/27/18, his exact language was the following:

“Interest rates are still low by historical standards, and they remain just below the broad range of estimates of the level that would be neutral for the economy – that is, neither speeding up nor slowing down growth.”

The current “target level” for the Fed Funds rate, the primary interest rate lever used to impact the economy by altering interest rates, is currently in a range of 2.25-2.50%. What Powell seems to have implied, or what the market gleaned from the comment above, is that the Fed may only increase the target rate by another 0.25-0.50% as opposed to the 1.00-1.50% forecast by the very same Fed just two months prior. The extent to which the Fed is willing to tighten monetary policy by raising interest rates has a dramatic impact on the amount of risk investors are willing to take. Thus, with the dovish change in Powell’s language, the stock market took off.

Just The Facts

The data on the economy remains robust. Annualized GDP growth through the 3rd quarter of 2018 was 3.3% and the unemployment rate sat near a historic low at 3.9%. The regional surveys from the Fed consistently reflect that companies are having difficulty finding qualified workers, which implies that demand is good and wage growth, a key determinant of inflation, is likely to move higher. The index of Leading Economic Indicators remains solidly positive and consumer and business sentiment surveys nationally, while weakening, continue to point towards expansion.  

Data Courtesy: St. Louis Federal Reserve

Examining charts of various measures of inflation also offers insight into current circumstances. The traditional measures of inflation, Consumer Price Inflation (CPI) and Core (ex-food & Energy) CPI seem benign with core levels at roughly 2.2% although those indicators have declined modestly in recent months.

Data Courtesy: St. Louis Federal Reserve

Alternative inflation indicators like the Employment Cost Index (ECI) wages and average hourly earnings reflect a steady trend of rising wage pressures as shown in the chart below.

Data Courtesy: St. Louis Federal Reserve

The chart below uses the ECI Wages and Salaries data from above and compares it with two components of compensation from the NFIB small business survey. As shown, both metrics demonstrate mounting wage pressures. The NFIB survey shows that companies planning to raise worker compensation is trending higher. Additionally, the survey shows that the single biggest problem for small business is availability of quality labor (correlation using 9-month lead is over 76%) and that measure is also trending higher.

Data Courtesy: St. Louis Federal Reserve

Manufacturing activity captured via the Purchasing Managers Index (PMI) appears to lead CPI with some durability. The correlation is 52% since 2000 and 76% since 2006. Given the current level of manufacturing activity, it suggests that Core CPI should remain above 2.0% over the next several months.

Data Courtesy: St. Louis Federal Reserve

Economies Are Hard To Forecast

Economic systems are complex with many hidden, unobservable and non-linear relationships making economic activity very difficult to forecast. However, by applying simple logic about possible outcomes, we can better frame the risks of higher inflation due to wage pressures. If, as is currently forecast, GDP growth begins to gradually decline as the effects of tax reform and fiscal stimulus diminish, then we should expect gains in employment to moderate. That scenario does not necessarily argue for unemployment to rise which leaves the current labor market situation tight. The effects described above would remain well in place and higher labor costs could reasonably push inflation higher. Higher inflation would put upward pressure on long-term interest rates while creating a headwind for corporate profits, margins and stock prices. That would not be good for most investors.

Another scenario, again given the difficulties associated with forecasting GDP, is that economic growth does not moderate as much as expected and remains somewhat above the post-crisis trend. Labor costs, in that case, would accelerate and could cause wage inflation to move meaningfully higher. Clearly, the risks emanating from that scenario would be very bad for both stocks and bonds and thus a world enamored with passive investing and awash in 60/40 portfolios.

Other Info

A cursory review of other economic data provides even more evidence that the level of interest rates is well below what it should be. Household net worth, industrial production and retail sales are all more than fully recovered from the crisis and have been for some time. Furthermore, the U.S. never experienced deflation, and thus the common point of comparison and rationalization for gradual policy adjustments – that the U.S. could end up in a situation akin to what Japan has been experiencing and combatting for decades – rings hollow. The counter-factual argument is that Fed actions prevented a “Japan-like” outcome, but there is no evidence to support that claim. All this strongly argues that the Fed Funds target rate remains not just slightly accommodative as Powell acknowledges but extremely accommodative.

The following graph, from our article Why Fed’s Monetary Policy Is Still Very Accommodative, shows that the current level of monetary policy is accommodative and unprecedented over the last four decades.

Fortunetellers

Since the financial crisis, the Fed has exerted ever more influence over the economy through extraordinary policy measures. Importantly, their financial crisis and post-crisis involvement came partially as a result of their prior involvement in stoking a housing and stock market bubble that in part led to the crisis.

Now, as they seek to reverse out of those policies, their job is proving more difficult than anticipated and contrary to what Bernanke, Yellen and Dudley told us as they were enacting said policy. That circumstance does not appear to have imposed much humility on the Fed. Despite all their innovations, such as r*, complex labor market indicators, data dependency and forward guidance, Jerome Powell is flying just as blind as Bernanke was in the early innings of the financial crisis. He confirmed this by reasserting and then reversing prior language around his assessment of the economy four times since October 3, 2018. This is not the most confidence-inspiring tactic for a Fed Chairman.

A more reliable approach to monetary policy would be to allow markets to dictate prices. Billions of buyers and sellers, borrowers and lenders, who transact every day are collectively better informed than the small group of unelected and unaccountable figureheads at the Fed. Should the Fed find the urge to become engaged, and it would be a rare occasion indeed, they should respond to market forces and stay out of the way of the robust pricing mechanisms of markets.

Summary

The analogy for the Fed and its approach to monetary policy is one of a driver on a curvy country road. A licensed driver obeying the law who pays attention to the speed limit and other important road signs indicating warnings should be able to successfully navigate to a destination. If, however, the driver decides to navigate by anticipating the contours of the road and confidently driving above the speed limit, he will eventually end up off the road, through a fence or over a cliff. Unfortunately, we are all passengers along for the Fed’s ride currently.

Most of us are willing passengers, having been convinced that the Fed knows what they are doing. That is understandable given the influence on markets from the trillions in liquidity they supplied, but it is not true. The consequences of years of excessive policy will eventually begin to reveal themselves, and we posit they already are. The intersection of manipulated economic forces and societal outrage are exhibit A. What is so confounding, is the misplaced trust in the entities and leaders that are causing the problems described.

R* and all the other economic terms that supposedly guide policy-makers are conjured from the realm of scientific economic analysis but human beings and their behavior cannot be modeled in a spreadsheet. The problem is the failure to apply proper humility or even common sense when crafting the formulas on which policies rest and livelihoods depend.

Normal Is In The Eye Of The Beholder – RIA PRO

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester, and discussed HERE, it turns out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence:

Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.”

The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

This article was made exclusive to RIA Pro subscribers on February 25th. We share it with you to demonstrate one of the many benefits of subscribing to RIA Pro. If you would like to take us for a test ride, use the coupon code PRO30 for a 30-day free trial. To learn more please click here.

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

Normal is in the Eye of the Beholder

A scorpion asks a frog to ferry it across a river. The frog tells the scorpion he fears being stung. The scorpion promises not to sting the frog saying if I did so we would both drown. Considering this, the frog agrees, but midway across the river the scorpion stings the frog, dooming them both. When the frog asks why the scorpion replies that it was in its nature to do so.

On February 20, 2019, the Federal Reserve released the minutes from their January policy (FOMC) meeting. As leaked last week by Fed Governor Loretta Mester and discussed HERE, it turs out that in January the committee did indeed discuss a process to end the systematic reduction of the Fed’s balance sheet, better known as Quantitative Tightening (QT).

Within the minutes was the following sentence: “Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve balance sheet.” The message implies that when the process of reducing the balance sheet ends the Fed’s balance sheet will be normalized. Is that really the case?

The New Normal

Before discussing the implications regarding the present size of the Fed’s balance sheet, we help you decide if the balance sheet will truly be normal come later 2019. The graph below plots the Federal Reserve’s Adjusted Monetary Base, a well-correlated proxy for the Fed’s balance sheet, as a percentage of GDP. The black part of the line projects the current pace of reduction ($50 billion/month) through December.

Data Courtesy: St Louis Federal Reserve

As shown, even if the Fed reduces their holdings through the remainder of the year, the balance sheet will still be nearly three times larger as compared to the economy than in the 25 years before the financial crisis. Would you characterize the current level of the balance sheet as normal?  

Implications

If you answered no to the question, then you should carefully consider the implications associated with a permanently inflated Fed balance sheet. In this article, we discuss three such issues; inflation, safety/soundness, and future policy firepower.

Potential Inflation

When the Fed conducted Quantitative Easing (QE) with the primary purpose of injecting fresh liquidity into the capital markets, the size of their balance sheet rose as they purchased Treasury and mortgage-backed securities from their network of banks and brokers. To pay for the securities the Fed digitally credited the accounts of those firms for the dollar amount owed. A large portion of the money used to buy the securities ultimately ended up in the excess reserve accounts of the largest banks.  Before explaining why this matters we step back for a brief banking lesson.

Under the fractional reserve banking system, banks can lend a multiple of their reserves (deposits and capital). The multiple, governed by the Fed, is known as the reserve ratio. Banks maximize profits by leveraging reserves as much as the reserve ratio allows. Before 2008 the amount of excess reserves was minimal, meaning banks maximized the amount of loans they created based on reserves.

Currently, banks are sitting on about $1.5 trillion of excess reserves that are unconstrained. To put that in context, the average from 1985 to 2007 was only $1.3 billion. This large sum of untapped reserves means that banks can lend, and create money far easier than at any time in the past. If they were to do this the growth in the amount of credit in the system could surge well beyond the rate of economic growth and generate inflation. This potential did not exist before 2008.

Safety and Soundness

Banks and brokers in 2008 were leveraged as much as 40:1. Lehman Brothers, for example, was levered 44:1 at the time they filed for bankruptcy. Many banks failed, and a good majority required unprecedented action by the Fed and U.S. government to bail them out. Clearly the combination of declining asset values and too much leverage broke the financial system.  

The Fed currently has $39 billion of capital supporting $3.9 Trillion of assets. They are leveraged 100:1, meaning a 1% percent loss on their assets would wipe out their capital. This amount of leverage is approximately three times that which was normal prior to the crisis.

Fortunately, the Fed does not re-value their assets so the daily volatility of the fixed income markets cannot bankrupt them. Regardless, one would think the Fed would apply similar safety and soundness measures that they require of their member banks.

Ultimately, this inordinate amount of leverage raises questions about Federal Reserve integrity and the value of the dollar which is issued and supported by the Fed. Fiat currency regimes perch delicately on trust. Should we trust the entity that controls the money supply when they employ such unsound banking practices? More importantly, if I am a foreigner using U.S. dollars, the world’s reserve currency, should I be concerned and possibly question my trust in the Fed?  What is the risk that a problem emerges and to recapitalize the Fed simply prints dollars causing a significant devaluation of U.S. dollars? At what point does the risk-free status of U.S. Treasuries become challenged due to unsound Fed practices?

Next Recession

The Fed’s balance sheet is about four times larger today than it was at the start of the last recession. With the Fed Funds rate only at 2.25%, the Fed has little room to stimulate the economy and support the financial markets using traditional measures. During the next recession the onus will assuredly be put on QE. The questions raised above and many others are of much greater concern if the Fed were to boost their balance sheet to $6, $8 or even $10 trillion. Such growth would further increase the already high level of leverage and potentially introduce fresh concerns about the real value of the U.S. dollar. This raises the specter of a negatively self-reinforcing feedback loop. 

Summary

Over the last year, the market has struggled as the Fed steadily reduced the size of their balance sheet. The S&P 500 is unchanged over the past 13 months. The liquidity pumped into the markets during QE 1, 2, and 3 is being removed, and asset prices which rose on that liquidity are now falling as it is removed. The Fed is clearly taking notice. In December Jerome Powell said the QT process was on “autopilot” with no changes in sight. A week later, with the market swooning, he discussed the need to “manage” QT. “Autopilot” became “manage” which has now turned to “end” in only two months.

If the Fed’s mandate is to support asset prices, this behavior makes sense.

To the contrary, the congressionally chartered mandate is clear; they are supposed to promote stable prices and full employment. Our concern is that capital markets, which are heavily dependent on the Fed and seemingly insensitive to price and valuation, are promoting instability and gross misallocation of capital. One cannot fault markets; they are responding as one should expect on the basis of Fed posture and the prior reaction function. Markets are properly agnostic under such circumstances. It is the Fed that has created an environment that leads markets to react in the ways that it does.

Like the fable of the scorpion and frog, the Fed is trusting markets to not destabilize as long as the Fed gives it a ride. While the relationship may seem cooperative today, it is not in the nature of markets to comply with foolish policy-making. Just like it is natural for scorpions to sting, it is natural for markets to find and expose weakness.

Regardless of the Fed’s characterization of a normal balance sheet, the normalization process is far from normal. What the Fed is doing is redefining “normal” to support inflated and over-valued asset prices and accommodate an unruly market. This will only aggravate any deeper problems lurking.

At the end of the day, are we ever going to have price discovery in the natural way or is the Fed going to step in every single time the markets try to normalize?” –Danielle DiMartino Booth

Chairman Powell – You’re Fired

I’m a low interest rate person – Donald Trump 2016

On Donald Trump’s hit TV show, The Apprentice, contestants competed to be Trump’s chief apprentice. Predictably, each show ended when the field of contestants was narrowed down by the firing of a would-be apprentice. While the show was pure entertainment, we suspect Trump’s management style was on full display. Trump has run private organizations his entire career. Within these organizations, he had a tremendous amount of unilateral control. Unlike what is required in the role of President or that of a corporate executive for a public company, Trump largely did what he wanted to do.

On numerous occasions, Trump has claimed the stock market is his “mark-to-market.” In other words, the market is the barometer of his job performance. We think this is a ludicrous comment and one that the President will likely regret. He has made this comment on repeated occasions, leading us to conclude that, whether he believes it or not, he has tethered himself to the market as a gauge of performance in the mind of the public. We have little doubt that the President will do everything in his power to ensure the market does not make him look bad.

Warning Shots Across the Bow

On June 29, 2018, Trump’s Economic Advisor Lawrence Kudlow delivered a warning to Chairman Powell saying he hoped that the Federal Reserve (Fed) would raise interest rates “very slowly.”

Almost a month later we learned that Kudlow was not just speaking for himself but likely on behalf of his boss, Donald Trump. During an interview with CNBC, on July 20, 2018, the President expanded on Kudlow’s comments voicing concern with the Fed hiking interest rates. Trump told CNBC’s Joe Kernen that he does not approve [of rate hikes], even though he put a “very good man in” at the Fed referring to Chairman Jerome Powell.

“I’m not thrilled,” Trump added. “Because we go up and every time you go up they want to raise rates again. I don’t really — I am not happy about it. But at the same time I’m letting them do what they feel is best.”

“As of this moment, I would not see that this would be a big deal yet but on the other hand it is a danger sign,” he said.

Two months later in August of 2018, Bloomberg ran the following article:

Trump Said to Complain Powell Hasn’t Been Cheap-Money Fed Chair

“President Donald Trump said he expected Jerome Powell to be a cheap-money Fed chairman and lamented to wealthy Republican donors at a Hamptons fundraiser on Friday that his nominee instead raised interest rates, according to three people present.”

On October 10, 2018, following a 3% sell-off in the equity markets, CNBC reported on Donald Trump’s most harsh criticism of the Fed to date.  Trump said, “I think the Fed is making a mistake. They’re so tight. I think the Fed has gone crazy.”

Again-“I think the Fed has gone crazy

These comments and others come as the Fed is publicly stating their preference for multiple rate hikes and further balance sheet reduction in the coming 12-24 months. The markets, as discussed in our article Everyone Hears the Fed but Few are Listening, are not priced for the same expectations. This is becoming evident with the pickup in volatility in the stock and bond markets.  There is little doubt that a hawkish tone from Chairman Powell and other governors will increasingly wear on an equity market that is desperately dependent on ultra-low interest rates.

Who can stop the Fed?

We think there is an obstacle that might stand in the Fed’s way of further rate hikes and balance sheet reductions.

Consider a scenario where the stock market drops 20-25% or more, and the Fed continues raising rates and maintaining a hawkish tenor.

We believe this scenario is well within the realm of possibilities. Powell does not appear to be like Yellen, Bernanke or Greenspan with a finger on the trigger ready to support the markets at early signs of disruption. In his most recent press conference on September 26, 2018, Powell mentioned that the Fed would react to the stock market but only if the correction was both “significant” and “lasting.”

The word “significant” suggests he would need to see evidence of such a move causing financial instability. “Lasting” implies Powell’s reaction time to such instability will be much slower than his predecessors. Taken along with his 2013 comments that low rates and large-scale asset purchases (QE) “might drive excessive risk-taking or cause bubbles in financial assets and housing” further seems to support the notion that he would be slow to react.

Implications

President Trump’s ire over Fed policy will likely boil over if the Fed sits on their hands while the President’s popularity “mark-to-market” is deteriorating.

This leads us to a question of utmost importance. Can the President of the United States fire the Chairman of the Fed? If so, what might be the implications?

The answer to the first question is yes. Pedro da Costa of Business Insider wrote on this topic. In his article (link) he shared the following from the Federal Reserve Act (link):

Given that the President can fire the Fed Chairman for “cause” raises the question of implications were such an event to occur.  The Fed was organized as a politically independent entity. Congress designed it this way so that monetary policy would be based on what is best for the economy in the long run and not predicated on the short-term desires of the ruling political party and/or President.

Although a President has never fired a Fed Chairman since its inception in 1913, the Fed’s independence has been called into question numerous times. In the 1960’s, Lyndon Johnson is known to have physically pushed Fed Chairman William McChesney Martin around the Oval Office demanding that he ease policy. Martin acquiesced. In the months leading up to the 1972 election, Richard Nixon used a variety of methods including verbal threats and false leaks to the press to influence Arthur Burns toward a more dovish policy stance.

If hawkish Fed policy actions, as proposed above, result in a large market correction and Trump were to fire Fed Chairman Jerome Powell, it is plausible that the all-important veil of Fed independence would be pierced. Although pure conjecture, it does not seem unreasonable to consider what Trump might do in the event of a large and persistent market drawdown. Were he to replace the Fed chair with a more loyal “team player” willing to introduce even more drastic monetary actions than seen over the last ten years, it would certainly add complexity and risk to the economic outlook. The precedent for this was established when President Trump recently nominated former Richmond Fed advisor and economics professor Marvin Goodfriend to fill an open position on the Fed’s Board of Governors. Although Goodfriend has been critical of bond buying programs, “he (Goodfriend) has a radical willingness to embrace deeply negative rates.” –The Financial Times

Such a turn of events might initially be very favorable for equity markets, but would likely raise doubts about market values for many investors and raise serious questions about the integrity of the U.S. dollar. Lowering rates even further leaves the U.S. debt problem unchecked and potentially unleashes inflation, a highly toxic combination. A continuation of overly dovish policy would likely bolster further expansion of debt well beyond the nation’s ability to service it. Additionally, if inflation did move higher in response, bond markets would no doubt eventually respond by driving interest rates higher. The can may be kicked further but the consequences, both current and future, will become ever harsher.

Why Fed’s Monetary Policy Is Still Very Accommodative

Here are two statements from the Federal Reserve’s Federal Open Market Committee (FOMC) immediately following their interest rate decisions of August 1, 2018 and September 26, 2018.

August 1, 2018 – In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1.75-2.00%. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

September 26, 2018 – In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2.00-2.25%. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

As you can see, the second statement eliminated language around its belief that monetary policy remained accommodative, which it clearly stated in the August release. Since the media and analysts closely track changes in Fed statements to glean intent with regards to future rate increases and current and future economic conditions, the natural conclusion was that the 25 bps rate hike in September moved the Fed from “accommodative” to “not accommodative”, though not necessarily “restrictive”.

Interestingly, Chairman Powell’s subsequent comments to PBS six days after the September FOMC meeting seem to cast doubts on that conclusion.

“The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore,” Powell said.

Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral,” he added. “We may go past neutral, but we’re a long way from neutral at this point, probably.”

So, is monetary policy currently accommodative or not?

This article provides a few charts aimed toward making sense of the contradictory statements from Fed officials so you can decide for yourself if policy is accommodative. Given the importance that monetary policy plays in asset pricing, a clear understanding of the Fed’s intent is extremely valuable. For more on our latest thoughts regarding Fed policy intentions and market expectations, please read our article Everyone Hears the Fed, But Few Listen.

Fed Funds

The Fed manages the level of the fed funds rate to influence other interest rates and thus meet their congressionally mandated employment and price objectives for the U.S. economy. To do so, the Fed conducts various operations in the money markets.

The graph below shows fed funds rate and its long-term average.  Since the end of 2015, the fed funds rate has risen 2% from its level near 0% that persisted for many years in the wake of the financial crisis.  Yet, the fed funds rate is still at a level that has only been experienced in a few short-lived instances in the last 70 years.

Data Courtesy: St. Louis Federal Reserve

Comparing the fed funds rate over time is not the best determinant of whether policy is accommodative or restrictive. Better context is gained by looking at the fed funds rate relative to the rate of nominal economic growth (GDP) and inflation (CPI).

Data Courtesy: St. Louis Federal Reserve

As shown in the graphs, the current fed funds rate is 3.69% below the rate of nominal economic growth (based on Q2 2018 data) and 0.95% below the rate of inflation. It is also worth noting that longer-term real (adjusted for inflation) Treasury yields, as shown in the second graph, are all near zero. This means that the current yields on Treasury securities are about equal with the current rate of inflation. While real rates have finally risen from financial crisis-era levels, history shows us that real rates remain far from normal.

To better understand why this is important, please read our article Wicksell’s Elegant Model.

The bottom line is that, while the fed funds rate is on the rise, it is far below absolute and relative levels that serve as historical norms. Based on the data shown above, further increases of 2-4% would put the fed funds rate on par with historical comparisons.

Balance Sheet

In 2009, with the fed funds rate pinned at zero percent, the Fed introduced Quantitative Easing (QE). Through three separate acts of buying U.S. Treasuries and mortgage backed securities (QE 1,2, and 3) the Fed’s balance sheet rose five-fold from about $800 billion to $4.3 trillion. The graph below charts the monetary base, which soared as a direct result of QE and has recently begun to decline due to Quantitative Tightening (QT), the Fed’s active effort to reduce the amount of assets on their balance sheet.

Data Courtesy: St. Louis Federal Reserve

Quantifying Stimulus

The next graph marries the two methods the Fed uses to conduct policy to quantify the amount of stimulus in interest rate terms. The amount of excess fed funds rate stimulus (teal) is calculated as nominal GDP growth less the fed funds rate. QE related stimulus (orange) is based on a rule Ben Bernanke laid out in 2010. He approximated that every additional $6-10bn of excess reserves held by banks (a byproduct of QE) was roughly equivalent to lowering interest rates one basis point. Together the total represents the amount of interest rate stimulus.

Data Courtesy: St. Louis Federal Reserve

Currently, between QE and a historically low fed funds rate, the amount of stimulus being applied would, under normal conditions, be equivalent to dropping the Fed Funds rate by 6.08%. While that figure may seem beyond belief, consider that excess reserves are currently $1.9 trillion as compared to near zero for the decades preceding the financial crisis and the fed funds rate is currently 3.69% below nominal GDP.

Essentially, the combination of an abnormally low fed funds rate coupled with the still outsized, but declining gradually, effects of QE argue that stimulus is still grossly accommodative. Incredibly, this is all occurring at a point in time when most economists believe the economy to be at full employment, growth is improving, stocks are at all-time highs and all sentiment indicators are at or near record high levels.

Global Accommodation

Thus far, we have only focused on the amount of accommodation provided by the Fed. Also worthy of consideration, the policies of the world’s largest economic powers have an impact on the U.S. economy. The following graph demonstrates the amount of stimulus being provided by the largest central banks.

Data Courtesy: St. Louis Federal Reserve and Bloomberg

Summary

Is Fed policy accommodative?

YES!

If you believe, as we do, that it is not only accommodative but irresponsibly accommodative, you will also appreciate the fact that the Fed has room to raise interest rates far more than investors are currently pricing in. Furthermore, any threats of inflation will likely push the Fed to restrain rising prices by acting more aggressively. This too falls outside the realm of current market expectations.

What we know is that financial asset prices have been the primary beneficiary of years of accommodative monetary policy at the expense of economic and social stability. As Stanley Druckenmiller said in his recent interview on RealVision TV:

“You know, intuitively, you can make a case that we’re going to have a financial crisis bigger than the last one because all they (the central bankers) did was triple down on what, in my opinion, caused it. I don’t know who the boogeyman is this time. I do know that there are zombies out there. Are they going to infect the banking system the way they did the last time? I don’t know. What I do know is we seem to learn something from every crisis, and this one we didn’t learn anything. And in my opinion, we tripled down on what caused the crisis. And we tripled down on it globally.”

Given the boost to asset prices caused by Fed policy, investors would be well-advised to pay close attention to the Fed’s words, their actions and critically, their inconsistencies.